Analysis of delinquencies in CRE debt : an approach to understanding risk and pricing

Abstract

Commercial Real Estate (CRE) debt has been the most staple form of capital for the real estate industry in the US for decades. However, a lot has changed in the CRE debt landscape since the Global Financial Crisis. With growing regulatory constraints for traditional lenders, and massive amounts of global capital chasing private market investments, private debt funds are emerging as a reliable alternate source of debt for the industry. With the current market cycle showing signs of an end-cycle environment, private debt funds/strategies have become even more popular with investors for their potential to enhance returns on a risk-adjusted basis. The intent of most such funds is to achieve "equity-like" returns at "lower risk". Returns are for everyone to see - Risk is what is difficult to capture. The main objective of this study is to unravel the risk characteristics of CRE debt, and to empirically quantify the risk involved in CRE lending.

A credit risk approach is adopted to do an extensive analysis of delinquencies in a portfolio of 65,533 CRE loans originated over 23 years; all loans are/have been a part of CMBS collateral, and their entire performance track record is sourced from Trepp LLC. The study uses the three pillars of the credit risk approach - Incidence of Default, Loss Severity, and Time to Default, and applies them to five distinct segments of the portfolio - Aggregate, Market Cycle, Asset Class, Origination Cohort, and Loan-to-Value Ratio, to come up with a comprehensive set of insights and measurements on risk. The study finds that CRE loans get incrementally risky as Loan-to-Value ratios get higher; quantitative metrics are derived to highlight the relative differences in risk. It also finds that loans originated in the later years of a market cycle tend to be much riskier than those originated earlier in a cycle.

The analysis brings out many more nuanced trends and metrics that come together to portray a complete risk profile of CRE debt. The study concludes with a summary of the high-level takeaways, and a brief discussion on how the derived metrics can feed into pricing decisions.